*54 Decisions will be entered for the respondent.
Petitioners had a right under a contract of employment to salary and bonuses, the bonuses under the different conditions being paid in cash or in common stock of the employer-corporation, a method being provided by the contract for the determination of the price at which the stock should be computed. The contract used the word "option." Held, that the contract was one of employment, that the stock was received as compensation for services rendered, and that the difference between the price at which received and the fair market value of the stock when received was properly included by the Commissioner in the gross income of petitioners. Commissioner v. Smith, 324 U.S. 177; Regulations 111, sec. 29.22 (a)-1; and I. T. 3795.
*695 These proceedings, consolidated for hearing, involve proposed deficiencies in Federal income taxes against petitioners and claims of overpayment for 1946 as follows:
| Otto C. Schultz | Maurice S. | |
| Petitioner | Docket No. | Jelenko Docket |
| 27242 | No. 27243 | |
| Amount of deficiency | $ 51.28 | $ 672.28 |
| Claimed overpayment | 6,360.02 | 9,203.97 |
The only question presented is whether the petitioners are taxable in 1946 on the difference between the price at which they obtained stock in their employer-corporation under a bonus agreement, and market value of the stock when obtained in 1946.
These proceedings were submitted on a stipulation of facts and oral and documentary evidence. The facts stipulated are so found and are incorporated herein by this reference along with other facts found from the oral and documentary evidence.
FINDINGS OF FACT.
Petitioner Otto C. Schultz is an individual, formerly residing in Clayton, Missouri, and now residing in Whittier, California. Petitioner Maurice S. Jelenko is an individual, residing*56 in St. Louis, Missouri. Each filed his income tax return for 1946 with the collector of internal revenue for the first district of Missouri. Each petitioner *696 kept his books and filed his income tax return, on a calendar year basis, for 1946 on the cash basis.
Petitioners were during 1946 both employed by Stix, Baer & Fuller Company (hereinafter referred to as the company), which was on a fiscal year ending January 31. Each petitioner was working under a written contract, dated August 17, 1934. The contracts provided for employment of petitioners by the company, petitioners agreeing to devote their entire time to company business and to comply with all company rules and regulations applicable to their positions; that they should receive bonuses in addition to their semimonthly salaries, the bonuses to be 2 1/2 per cent of the net profits of the company, if it had net profits of $ 150,000 or more; that the bonuses were to be paid in the company's common stock on the first $ 150,000, and above $ 150,000 equally in cash and common stock subject to the election of the petitioners to take the entire bonus in common stock; and that "in determining the price at which said stock*57 shall be computed" each petitioner should have the option of having the stock figured at market price on January 31 (less 20 per cent unless the stock was selling for less than $ 15) or at average sales price for 6 months preceding January 31 on the St. Louis stock exchange. By an amendment dated January 10, 1937, the method was limited to the one method, that is, on the basis of the average price of the last sale for the months of August, September, October, November, December, and January of any year (hereinafter sometimes referred to as the average price) with further provision that if the average was $ 15 or more the price of the stock was to be 20 per cent less. The petitioners were not to be entitled to the bonus for any year unless they were in the active continuous employ of the company during that year, provided that if through no fault of their own the petitioners were unable to be in actual continuous employ during such year, any bonus should be prorated. The contracts, as originally executed, provided that stock acquired under these contracts was to be held in escrow for a period of 4 years, except that in case of incapacity of the petitioner to perform services required*58 under the contract, or in case of his death, or discharge, the stock should be delivered. In case the petitioner severed connection with the company, he "shall not have the stock * * *." By an amendment, dated February 1, 1946, all stock previously acquired by the petitioners in pursuance of their contracts was to be released from escrow upon demand and petitioners were to be permitted to sell, assign and dispose of the stock or any part thereof without further limitations or restrictions; and future bonuses were to be payable in cash, and none in stock.
The contracts also provided that in the event the petitioners intended to exercise their option to take stock under the terms of the *697 contracts, they were to notify the company of their decision to exercise the option within 90 days after their right to the options became established and should they fail to advise the company of their decisions as to what option they desired to take, then
* * * first party [the company] shall have the option to pay the amount due second party under the terms hereof either in stock or cash, and first party shall have the option of selecting which method * * * shall be considered as the basis*59 for determining the price of stock to be delivered to said second party under the terms hereof.
On February 1, 1941, the petitioners' contracts were amended to provide that for all future years there was to be no bonus on the first $ 200,000 profits if the total profits were less than $ 425,000 and that all future bonuses were to be paid one-half in cash and one-half in common stock of the company.
The contract prices, computed in accordance with the contracts, were, for the years 1935 to 1945, inclusive, below the price of $ 15 per share. The contract price for 1946 was $ 21.76 per share, computed by taking the average price of the last sales of the months August 1945 through January 1946, which resulted in $ 27.20, and deducting 20 per cent therefrom. In several years petitioners under verbal agreements with the company took less in stock than they were required to take under the terms of the written contracts.
The general reputation of petitioners with the company was that Otto C. Schultz as comptroller and Maurice S. Jelenko as general merchandise manager were the two most valued and important executives of the company. Such employees were hard to find and hard to keep.
On *60 January 31, 1946, petitioner Otto C. Schultz became entitled under his contract to a bonus of $ 37,611.30. One-half of the bonus was $ 18,805.65 as to which he agreed to and did take 864.23 shares of common stock of the company based on the contract price of $ 21.76 per share. In addition on February 1, 1946, he elected to and did take $ 2,954.35 of the other half of his bonus in common stock of the company which amounted to 135.77 shares of stock of the company at the contract price. On January 31, 1946, Maurice S. Jelenko became entitled under his contract to a bonus of $ 33,611.30, he and the company having agreed, beginning February 1, 1938, that his base salary be increased and his bonus reduced by $ 4,000 each year. One-half of the bonus was $ 16,805.65 as to which he agreed to and did take 772.32 shares of common stock of the company based on the contract price of $ 21.76 per share. In addition thereto on February 1, 1946, he elected to and did take $ 4,954.35 of the other half of his bonus in common stock of the company which amounted to 227.68 shares of the stock at the contract price. Therefore, the petitioners each obtained *698 under their contracts a total of*61 1,000 shares of the stock of the company during the year 1946.
The fair market value of the stock of the company on January 31 and February 1, 1946, was $ 34.50 per share and the difference between that value and the contract price of $ 21.76 was $ 12.74 per share, or $ 12,740 for the 1,000 shares received by each petitioner.
Prior to July 1, 1946, each petitioner and the company filed written consents, in duplicate, with the Commissioner of Internal Revenue, Washington, D. C., pursuant to and in conformity with the provisions of I. T. 3795 (1946-1 C. B. 15), with respect to the agreement and the stock so acquired by him in 1946.
The Commissioner of Internal Revenue on August 30, 1946, ruled that each petitioner realized taxable income by way of compensation to the extent of the fair market value of the 1,000 shares of the stock obtained by him under the contract. As a result of the ruling, each petitioner included in gross income in his return for 1946 the amount of the market value ($ 34.50) of the 1,000 shares, or $ 34,500.
On December 2, 1948, each petitioner filed a claim for refund on the ground that the difference of $ 12,740 between the contract*62 price ($ 21,760) and the market price ($ 34,500) of the 1,000 shares was not taxable compensation or taxable income in any form to him.
On September 7, 1946, the common stock of the company was split up on the basis of two for one, and petitioners each received 2 shares of new stock for each one share of old stock he held on that date. In December 1946, Otto C. Schultz sold 1,840 shares of the new stock which he acquired January 31, 1946, and in computing the net long term capital gain realized thereon he used as a cost basis $ 17.25 (one-half the fair market value of the old stock at date of receipt). It is agreed that if the Court should hold that the cost basis of the old stock to him is $ 21.76 (the contract price), then the computation of the net long term capital gain should be made on the basis of $ 10.88 (one-half the contract price), and that the net long term capital gain reported on his return for 1946 should thereby be increased.
OPINION.
The only question is whether the petitioners are taxable in 1946 on the difference between the price at which they obtained stock in their employer-corporation under an employee-bonus agreement and the fair market value of the stock*63 when it was obtained in 1946.
The courts, over a long period of time, have considered questions similar to the one here involved. In 1946, after the Supreme Court's decision in Commissioner v. Smith, 324 U.S. 177, the Commissioner promulgated new regulations in regard to this question. The change *699 appears in T. D. 5507 (1946-1 C. B. 18) and was made effective only as to agreements entered into after February 26, 1945 (the date of the Supreme Court's opinion in the Smith case). In effect the change was that thereafter if property was transferred by an employer to an employee at less than fair market value, the difference is in the nature of compensation, includible in gross income, and that the property shall take a basis of fair market value at time of transfer. It is clear, as provided in T. D. 5507, that property transferred by an employer to an employee pursuant to the exercise of any option granted to the employee before February 26, 1945, must be considered in the light of the Smith case and prior regulations. Here the contract and all amendments, *64 providing the alleged option, were all prior to February 26, 1945, so far as resulting in the stock here involved, since the amendment of February 1, 1946, followed the receipt, on January 31, 1946, of the stock here involved.
Regulations 111, section 29.22 (a)-1 applied prior to February 26, 1945, and in pertinent part provides:
If property is transferred by a corporation to a shareholder, or by an employer to an employee, for an amount substantially less than its fair market value, regardless of whether the transfer is in the guise of a sale or exchange, such shareholder or employee shall include in gross income the difference between the amount paid for the property and the amount of its fair market value to the extent that such difference is in the nature of (1) compensation for services rendered or to be rendered or * * *.
The Commissioner's viewpoint on this subject, involving contracts granted prior to February 26, 1945, is in part founded on I. T. 3795 (1946-1 C. B. 15), the pertinent part of which is set forth in the margin. 1 In their attempt to show that the amount here in question was not income, the petitioners also rely on I. T. 3795. *65 The point of contention between the parties is their different interpretations of the part involving whether at the time the options were granted there was a substantial difference between the fair market value of the stock and *700 the option price. The petitioners claim that there was no substantial difference between the option price and the market price at the time the options were granted, while the respondent contends, secondarily, that there was a substantial difference.
*66 After study and analysis of I. T. 3795 and the situation in this case, it is our opinion that the question of "substantial difference between the fair market value of the stock and the option price therefor" -- as stated in I. T. 3795 -- is not involved in the instant situation, and that the only question for our consideration is whether within the purview of section 29.22 (a)-1 of Regulations 111 the petitioners as employees realized income by way of compensation through the exercise of the alleged option. Not only does the Smith case, supra (applicable to the situation here involved because it grows out of and depends upon contracts, including alleged options, prior to February 26, 1945), hold that if an employer as compensation for services rendered gives an employee an option to purchase stock in the corporation, at a price not then less than market value, the difference between option price and market value when the stock later is obtained under the option, is compensation for services and income taxable to the employee; but if we here apply I. T. 3795 the result is the same. For we find I. T. 3795 to provide, in effect, that an exercise of an option granted to an employee*67 prior to February 26, 1945, does not result in income to the employee by way of compensation (if as was done here there is written consent agreeing to use of market price as basis) but with two definite exceptions:
* * * unless [a] at the time such option was granted there was a substantial difference between the fair market value of the stock and the option price therefor, or [b], within the purview of section 29.22 (a)-1 of Regulations 111 prior to the amendments made by Treasury Decision 5507, supra, the employee would otherwise clearly realize income by way of compensation through the exercise * * * of the option, * * *.
Obviously, therefore, if [b] here applies it is unnecessary to consider [a] as to whether there was substantial difference between fair market value and option price. It is clear to us that the effect of I. T. 3795 was that the new provisions, if there was any option granted prior to February 26, 1945, would not apply if there was such substantial difference between fair market value and option price, but that in any event if the case was one coming within the purview of section 29.22 (a)-1 of Regulations 111 in that any difference between fair market value*68 and price at which transferred was in the nature of compensation for services rendered, then such difference, at the time of transfer, must be reported in gross income. The contract here considered contains various references to employment, to bonus payable in stock or cash depending upon circumstances and the selection *701 made, and to the methods of "determining the price at which said stock shall be computed." It is patent, we think, that the alleged "option" was merely one of choice or election as to whether under different circumstances stock or cash should be taken as bonus and what method should be used in determining the price at which bonus stock should pass to an employee, as compensation. The contract first provides for such employment, for the devotion of the employee's entire time and his compliance with the company's regulations and rules applicable to his position. It then provides that "in addition to the regular semi-monthly compensation" the employee "shall receive a bonus" depending upon the net profits and payable, on the first $ 150,000, in stock and above that figure half in stock and half in cash with right on the part of the employee "to elect to take*69 the entire bonus in common stock." Then follows the provision for "determining the price at which said stock shall be computed." [The reference last above is to the original contract but on this question the amendments do not vary the situation.] The word "option" does not appear before the paragraph providing the two alternative methods of "determining the price at which said stock shall be computed," and it does not appear elsewhere than in the statement of the two alternative methods of figuring the stock except in the ninth paragraph where it is referred to as the option to take stock and where the word "option" is also referred to in reciting the corporation's right to pay "the amount due second party [the employee] under the terms hereof either in stock or cash" and of selecting which method theretofore provided shall be considered as basis for determining the price of stock to be delivered under the terms of the contract. We find in all this merely the mechanics of payment of a bonus in compensation of an employee. Though there was testimony by a former officer of the company (not of the petitioners, who did not testify) to the effect that the intent of the corporation in*70 the contract was not to pay compensation, the contract clearly contradicts it. The contract gives no right to take stock other than within the limit of the 2 1/2 per cent bonus. Therefore, in our view, even if the contract be considered to involve option within the purview of I. T. 3795, it is an option through the exercise of which the employee clearly realized income by way of compensation.
If on the other hand the contract does not contain option, the situation clearly falls within Regulations 111, section 29.22 (a)-1 for it is stipulated that the stock when taken by the petitioners under the contract on January 31, 1946, was taken at a price less than the fair market value as determined. Therefore under the ratio decidendi of the Smith case, supra, and the language of I. T. 3795 as to an employee clearly realizing income by way of compensation through the exercise of any option, within section 29.22 (a)-1 of the regulation, we *702 hold that all that was realized from the contracts, i. e., the full fair market value of the stock purchased under contracts here in question, constituted compensation for services. This conclusion renders it unnecessary, as we *71 have above indicated, to consider whether there was substantial difference between fair market value and option price at date of option.
Decisions will be entered for the respondent.
Footnotes
1. Treasury Decision 5507, supra, does not apply to the case of the exercise * * *, at whatever date, of an option which was granted to an employee prior to February 26, 1945, to purchase stock of the employer corporation * * *.
Accordingly, in view of the prior development of the regulations and interpretations relative to employee stock options * * * as respects an option granted to an employee prior to February 26, 1945, unless at the time such option was granted there was a substantial difference between the fair market value of the stock and the option price therefor, or, within the purview of section 29.22 (a)-1 of Regulations 111 prior to the amendments made by Treasury Decision 5507↩, supra, the employee would otherwise clearly realize income by way of compensation through the exercise * * * of the option, this office will hold that the exercise * * * of such option * * * does not result in income to the employee by way of compensation * * * provided, however, that on or before July 1, 1946, the employee * * * and the employer * * * file * * * written consents * * * agreeing that the basis to the employee * * * for the stock acquired or to be acquired pursuant to the option shall be the actual price paid therefor and that no deduction shall at any time be claimed attributable to any aspect of the option arrangement * * *.